Discount rates: Boring but important

This post will address two questions. What exactly is the discount rate? Did Sir Nicholas Stern, a former chief economist with the World Bank, use the wrong discount rate in his landmark 2006 report, the Stern Review on the Economics of Climate Change?

These may seem like abstruse economic questions, but for analyzing the cost-benefit analysis of climate action — whether we must act urgently or at leisure — the discount rate is probably the single most important factor. The discount rate basically represents the so-called time value of money, how much more $100 is worth to us today than next year.

A high discount rate means we would much rather have money today than in the future. The issue is complicated by the fact that society should have a lower discount rate than individuals, since a high “social” discount rate essentially means that we don’t value future generations much.

I must confess that even though I minored in economics and have followed the discount rate issue closely for years, after reading various recent blogs by economists, I realized I didn’t really understand it, particularly as it applies to climate change. I was not alone — The New York Timescompletely misunderstood Stern’s choice of discount rate.

Since discount rates are probably as important to the climate debate as feedbacks, I would very much commend the work of Australian economist John Quiggin. He explains why Stern’s choice of a low discount rate is fully justified — and why most critics are either wrong or confused or both — in an essay, “Stern and the critics on discounting” (PDF) and a lengthy blog post, “Discounting the Future yet Again.” The blog post has a fascinating quote from an Environmental Science & Policy article, “Discounting and the social cost of carbon” on the PTRP (Pure Time Rate of Preference):

The PRTP is the “utility discount rate”, which reflects our time preference for utility. Estimates of utility discount rates for individuals are almost always positive — an estimate of 1.5% is considered plausible for the UK for instance (HMTreasury, 2003) — for the simple reason that humans prefer good things to come earlier rather than later. Given the inevitability of death for individuals, a preference for benefits to accrue earlier rather than later is entirely sensible. At the social level, however, the arguments are more nuanced, and indeed whether or not the PRTP should be equal zero has been debated by philosophers and economists for decades. Cline (2004), for example, proposes to use a zero PRTP in evaluating climate change policies. Reasonable ethical considerations suggest using a zero PRTP–a positive PRTP involves placing a lower weight on the welfare of future generations, which is impartial and contrary to intergenerational equity. However, there are also persuasive arguments for employing a very small positive PRTP.

Quiggin’s blog post has a response section with a fascinating back-and-forth between one of the co-authors of this article (who doesn’t appear to stand behind what he wrote) and other economists, which is both informative and entertaining.

The bottom line is that Stern’s conservative critics are wrong. He made reasonable choices and gets reasonable results — the cost of action on climate change is far cheaper than the cost of inaction.